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If Tim Cook is right about AR, Lumentum is a buy

Despite high-profile announcements, few large US companies plan to use tax savings to boost investment or raise workers' pay, a CNBC survey found.

"I do think that a significant portion of the population of developed countries, and eventually all countries, will have AR experiences every day, almost like eating three meals a day, it will become that much a part of you," said Tim Cook, CEO of Apple in 2016.

If Tim Cook is right, then Lumentum should be one of the hottest technology companies of the next year. So the question is: Is Tim Cook right? I think he is and you should too. Here's why.

If Apple, the most valuable company in the world, is talking about Augmented Reality as the next great computing platform, then the companies that provide the technology to make this possible will be great investments.

Tune into Squawk Alley at 11 am. Dan Niles will be a guest.

Fast forward about a year to November 3, 2017 when the iPhoneX went on sale in retail stores worldwide. The big new feature is FaceID, which enabled users to unlock their iPhones using just their face which means remembering 50 different usernames and passwords is on the verge of becoming a relic of the past. And if that isn't enough to get you excited, it won't be long before augmented reality capabilities allow users to see digital images overlaid onto the physical world.

Want to be able to try on clothes in the digital world and then order them in the real world? Interested in seeing dragons in your living room? What if the dragons could race or battle? The possibilities are endless and coming your way in the near future compliments of the 3D sensing technology that is powered by lasers and built by – you guessed it – Lumentum.

Like most technologies, 3D sensing technology was developed many years ago. In 2010, JDSU Uniphase (the parent company of Lumentum) provided this laser technology for the Microsoft Kinect. It was a motion sensing input device for the Xbox 360 that would mimic your actions in the video games.

For example, one player could pretend to throw a fastball and the other player could pretend to hit it with characters on the screen mimicking the actions. There was no need to hold a controller like with the Wii. Having sold 8 million units in its first 60 days on the market, Kinect claimed the Guinness World Record of being the "fastest selling consumer electronics device." The high initial price, among other factors, eventually led to its demise. But times and technology costs change.

So how big could revenues from the 3D sensing market be? Each complete 3D Sensing module is currently over $10 with the laser content around $4. There are 1.5 billion smartphones sold worldwide each year. But by 2019, we are likely to get a world facing 3D camera. This world facing camera's laser will have to be stronger and as a result more expensive given it will be scanning your environment and not just your face.

To put this opportunity in perspective, Lumentum had less than $1 billion in revenues over the past twelve months. The revenue from the smartphone market alone should easily be above $10 billion over time even with normal price declines in the technology. Beyond 2019, this technology is likely to expand into other large markets requiring precise depth sensing such as industrial robotics and eventually self-driving automobiles.

So what are the companies that benefit from the ramp in 3D sensing technologies? There are many involved in making 3D sensing a reality. Here are some examples: Aixtron is the primary supplier of the deposition tools used for manufacturing the epitaxial wafers on which the lasers are built; IQE uses these tools to manufacturer the wafers that are supplied to the laser manufacturers; WIN Semiconductors manufactures the lasers on the wafers; Himax is collaborating with Qualcomm to make a 3D camera system for the China Android phones and uses the same laser supplier as Apple; ams AG supplies advanced optics to project the laser light onto the subject; STMicro supplies the image sensors to process the reflected laser light from the subject; and finally, LG Innotek combines all the components into a module.

But who actually designs the lasers for Apple without which none of these other companies would be seeing that demand? That would be Lumentum which has over 90 percent market share with Apple for 3D lasers.

3D sensing is going to be huge for Lumentum. It is a reinvention of the company. Lumentum will see their revenues related to Apple go from essentially zero in the first quarter of 2017 to at least $145 million in the last quarter of 2017 based on their guidance. In nine months, Apple will have gone from 0 percent to 40 percent of Lumentum's total revenues. The impact of 3D lasers on Lumentum as a percent of revenues is higher than for any of the other companies mentioned above.

So why has Lumentum's stock dramatically underperformed its 3D sensing peers? Lumentum's historical business of manufacturing optical modules for the telecom industry has been in a horrible decline over the past year. Lumentum's revenue from China has been cut in half from the peak and demand from US telecom carriers has also been weak given all of the merger activity over the past year.

As a result, Lumentum's optical communication revenue was down 22 percent year-over-year in the September quarter helping to drive a nearly 30 percent decline in the stock price from its recent peak. As a result, Lumentum's stock is up only 22 percent this year versus gains of 70 percent to over 300 percent for their 3D sensing peers.

This has created the buying opportunity in Lumentum's stock. We think it is only a matter of time before Lumentum's stock comes roaring back as 3D technology proliferates across the technology landscape in 2018 and the telecom business stabilizes and recovers.

So a company with this type of potential must be expensive, correct? Wrong! Because of the steep declines in their historical optical business, Lumentum trades only at a price-to-earnings (PE) ratio of 12 times. The stock seems extremely cheap compared to the other companies in the 3D sensing space. Closely related companies, Win Semiconductor which manufactures the lasers for Lumentum trades at 23 times 2018 earnings and IQE which supplies the epitaxial wafers on which these lasers are manufactured trades at 38 times.

We believe in 2018, Apple will also expand this technology to iPads which sell over 40 million units each year. The Chinese smartphone vendors will also introduce their own 3D sensing enabled smartphones in 2018. Lumentum already has orders in hand from one of these vendors.

As 3D technology expands from just the iPhone X, to iPads, Android Phones and multiple 3D cameras per phone, we think overall Lumentum revenues could be up even more than current expectations for 29 percent revenue growth in 2018 and 64 percent earnings growth.

We think there is an even bigger disparity in 2019 between current expectations and reality. Wall Street expects Lumentum's revenue growth to slow to 5 percent in 2019 and earnings growth to slow to 11 percent. But by 2019, the Android smartphone vendors which are over 80 percent of the units in the global market will start to catch up with Apple in adding 3D sensing features to the phone. Also Apple will have added a world facing 3D camera by this point doubling the number of lasers per phone.

In conclusion, as we eagerly await Luke Skywalker powering up his light saber once again, remember that lasers are not just for Jedis anymore and the technology will be coming to a phone near you. May Lumentum be with you.

Commentary by Dan Niles, founding partner of AlphaOne Capital Partners and senior portfolio manager of the AlphaOne Satori Fund. Previously, he was a managing director at Neuberger Berman, a subsidiary of Lehman Brothers.

Disclosures: This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Readers should not assume that any investments in securities, companies, sectors or markets identified and described were or will be profitable. This material has been prepared by AlphaOne Capital Partners, LLC on the basis of publicly available information, internally developed data and other third party sources believed to be reliable. AlphaOne Capital Partners, LLC has not sought to independently verify information taken from public and third party sources and does not make any representation or warranty as to the accuracy, completeness or reliability of the information contained herein. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Certain products and services may not be available in all jurisdictions or to all client types. Investing entails risks, including possible loss of principal.

The views expressed are those of Mr. Niles and do not represent the views of AlphaOne Capital Partners, LLC, its portfolio managers, employees or affiliates. These views are current as of the time of this presentation and are subject to change without notice. This material is not intended to be a formal research report or recommendation and should not be construed as an offer to sell or the solicitation of an offer to buy any security. AlphaOne Capital Partners, LLC and its clients may have long or short positions in some or all of the securities discussed. Before acting on any advice or recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Mr. Niles does not accept any responsibility to update any opinions or other information contained in this document. Before acting on any advice, opinions or recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

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